Chapter 7: Serial Problem

SP 7: Business Solutions – Accounting for Bad Debts 1. Adjusting Entry for Bad Debts on March 31, 2022 • Given: o Total Revenues for the first three months of 2022: $44,000 o Accounts Receivable balance on March 31, 2022: $22,867 o No balance in Allowance for Doubtful Accounts as of March 31. 1. Assumption (a): Bad debts estimated as 1% of total revenues o Calculation: $44,000 × 1% = $440 o Journal Entry:  Debit Bad Debts Expense: $440  Credit Allowance for Doubtful Accounts: $440 2. Assumption (b): Bad debts estimated as 2% of accounts receivable o Calculation: $22,867 × 2% = $457 (rounded) o Journal Entry:  Debit Bad Debts Expense: $457  Credit Allowance for Doubtful Accounts: $457 2. Adjusting Entry on June 30, 2022 • Given: o Accounts Receivable balance on June 30, 2022: $20,250 o One account of $100 has been written off since March 31. 3. Adjusting Entry Calculation: o Recalculate Allowance for Doubtful Accounts based on the June 30 accounts receivable using the 2% rate: o Calculation: $20,250 × 2% = $405 (desired balance in Allowance for Doubtful Accounts). o Since there was a write-off of $100, we adjust accordingly:  New Allowance Adjustment = $405 - (457 - 100) = $48 o Journal Entry:  Debit Bad Debts Expense: $48  Credit Allowance for Doubtful Accounts: $48 3. Consideration of the Direct Write-Off Method • Direct Write-Off vs. Allowance Method: o Direct Write-Off Method: This method is simple but doesn’t match expenses with revenues in the period they are earned, which can lead • to inaccurate financial reporting, especially if bad debts occur in different periods. o Allowance Method: Matches estimated bad debts to the period in which the related sales are recorded, providing more accurate financial results and is GAAP-compliant. Recommendation: Rey should continue with the allowance method rather than the direct write-off method, as it aligns with GAAP, offers better matching of revenues and expenses, and more accurately reflects the financial condition of the company. Beyond the Numbers (BTN) Questions BTN 7-1: Ethics Challenge 1. Effect of Lowering Doubtful Accounts Estimate: o Income Statement Impact: Reduces Bad Debts Expense, resulting in an artificially higher net income. o Balance Sheet Impact: Increases reported Accounts Receivable, overstating asset values and potentially misleading stakeholders. 2. Ethics Violation: o Adjusting allowances to boost income could be unethical as it manipulates financial results for personal gain. The purpose of estimates is to present a fair view of expected losses, not to influence compensation. 3. Internal Controls: o Require management review and approval of significant year-end adjustments, independent audits of estimates, and transparency in allowance calculation methods. Ensuring adjustments are based on historical data and trends rather than discretionary preferences would help maintain integrity. BTN 7-2: Communicating in Practice • Memorandum Explanation: o To: Sid Omar, Sales Manager o Subject: Explanation of Bad Debts Expense and Allowance for Doubtful Accounts Differences o Summary:  The Bad Debts Expense recorded each period represents an estimate of current period sales that might be uncollectible. The Allowance for Doubtful Accounts is an accumulated total that adjusts with actual write-offs and estimated additions over time.  This approach provides a reasonable estimate of potential losses while keeping the receivables balance realistic. Differences between the two accounts are normal and result from timing and the accrual of prior estimates. BTN 7-5: Entrepreneurial Decision – Plan A vs. Plan B Analysis 1. Net Income Calculation for Each Plan: o Plan A (Premium Service with Credit Cards):  Additional Credit Sales = $250,000  Costs:  Additional Wages = $135,500  Credit Card Fees = 4.75% of $250,000 = $11,875  Recordkeeping Costs = 6% of $250,000 = $15,000  Advertising Revenue Loss = $8,750  Total Costs = $135,500 + $11,875 + $15,000 + $8,750 = $171,125  Net Income Increase (Plan A) = $250,000 - $171,125 = $78,875 o Plan B (Merchandise Sales):  Additional Credit Sales = $500,000  Costs:  Cost of Goods Sold = $375,000  Recordkeeping/Shipping Costs = 4% of $500,000 = $20,000  Uncollectible Accounts = 6.2% of $500,000 = $31,000  Total Costs = $375,000 + $20,000 + $31,000 = $426,000  Net Income Increase (Plan B) = $500,000 - $426,000 = $74,000 2. Recommendation: o Financial Considerations: Plan A has a higher expected net income increase. However, Plan B has the potential to expand into a new market with merchandise sales, possibly diversifying revenue sources. o Nonfinancial Considerations: The decision should also consider factors such as brand impact, customer satisfaction, operational capabilities, and long-term growth strategies. If merchandise sales align well with Credit Karma's brand and infrastructure, it may warrant further consideration despite the lower immediate financial benefit.